Does austerity work?

20th February 2012

This piece from FTSE Global Markets outlines the debate : "If we look back at some of the examples of fiscal consolidation in the 1990s, it is clear that they were successful because the fiscal deficit was permanently corrected (this is the case in Canada, Sweden, Finland, Denmark, Italy and Ireland). Moreover, economic growth was not weakened; quite the contrary in fact. Unemployment declined in all cases, except in Italy."

"The current debate centres around whether this was achieved because of so-called ‘Ricardian neutrality' (in other words, a fall in the savings rate because of expectations of a lower tax burden at some point in the future due to cuts in government expenditure); or whether it was due to expansionary monetary policies and exchange-rate depreciation, and thereby to the stimulation of credit, investment and exports."

The message for policymakers is that if ‘Ricardian neutrality' has delivered more successful fiscal consolidations, then Eurozone countries should prioritise government spending cuts to reduce fiscal deficits. It also means that the fact they cannot devalue their currency is not as much of a barrier to rebuilding their economies as has been thought.

This study from Italian academic Roberto Perotti looks at the experience of Denmark, Finland, Sweden and Ireland – He analysed fiscal consolidation achieved by currency devaluation and that achieved by austerity measures. He suggests that that achieved by austerity measures tended to promote the greater expansion because it addressed an economy's competitiveness.

He says: "All four consolidations were associated with an expansion; but only in Denmark the driver of growth was internal demand. However, as in most exchange rate based stabilizations, after three years a long slump set in as the economy lost competitiveness."

Prioritising exports was also extremely important. He believes that the Denmark situation should be of particular interest for small EMU members today: "Denmark relied on an internal devaluation via wage restraint and income policies as a substitute for a devaluation. It exhibited all the typical features of an exchange-rate based stabilization. Inflation and interest rates fell fast, domestic demand initially boomed; but as competitiveness slowly worsened, the current account started worsening, and eventually growth ground to a halt and consumption declined for three years. The slump lasted for several years."

He added that private consumption typically increased one-and-a-half to two years after the start of the consolidation. In all cases, wage moderation was essential to maintain the benefits of the depreciations and to make possible the decline of the long nominal rates.

Mexico learned this lesson through bitter experience and theirs was an experience seen in a number of emerging market countries. It had already four years of recession before the government forged a joint agreement with official leaders of the labour, peasant, and business sectors to restrain wages and prices. This finally acted to curb the inflation that had held back economic progress since the start of the crisis in 1982.

This country study from the US Library of Congress gives a neat outline of the Mexican situation : "This two-stage program called for "shock" treatment in 1983 to restore macroeconomic balance, to be followed in 1984 and 1985 by a "gradualist" adjustment program to open the economy to market forces. The first phase was intended to restore price and financial stability by means of a sharp reduction in public spending and a steep peso devaluation. The government instituted a harsh austerity regime that held the growth in domestic spending far below the rise in total output.

"De la Madrid's first stabilization package did not work as expected. The government had expected lower inflation and more realistic prices to produce strong economic growth by 1984. This did not take place…The austerity measures and devaluations of 1983 eliminated both the fiscal and trade deficits, but at the cost of sharply reduced imports and a severe economic recession. Contrary to expectations, the inflation rate did not fall significantly, and voluntary private lending did not resume." Shifting the development strategy towards exports in 1985 helped the situation slightly, but it was only tackling inflation that really solved Mexico's problems and it still did not save it from another crisis in 1995.

None of these situations can completely reveal the likely outcome of the Eurozone crisis, particularly because elected governments are now not always in charge of their own destiny. In most cases, the debts were nowhere near the scale of those in Greece or other peripheral European countries. However, history reveals that economic expansion is possible after fiscal consolidation, and austerity measures have worked to achieve that, but only when combined with a pick-up in exports and inflation controls. As is becoming increasingly clear in the Eurozone, only one side of the equation – austerity – has been addressed.

15 thoughts on “Does austerity work?”

In Portugal more than 1 million people have jobs or gold-plated pensions from the State or State Companies which they got due to their political afiliation (in Portugal it’s very traditional for a party to grow the size of the State bureaucracy by, as soon as they win an election, giving out jobs to their members ). From what I hear from talking to my countrymen back there, the costs related to these have barelly been addressed.

At the same time, like in Spain, the country has a two-speed job market, with younger people having to work under short-term contracts with little or no job security while older people have undefined-term employment agreements which by law have a very high level of protection, making them very hard to fire even in lean times. This might explain why unemployment has grown (from all those easy to fire people in short-term contracts) all the while productivity per worker has decreased (from all the underused, hard to fire people in undefined-term contracts).

It’s true that in Portugal there are people with Gold Plated Pensions and jobs from the state but is completely false the number that you present. people working for the state are 560 000 are gold plated pensions are 20 000. When presenting numbers is better to inform yourself before presenting it

Telegraph has an article today from economist suggesting government should spend BoE “profits” from QE i.e. the interest on the gilts they bought with printed money – surreal.

Yesterday Krugman was on BBC World Service arguing that inflation hurt the rich (because they sat on piles of cash) and helped the very poor because their welfare benefits were “generally” inflation protected. I thought he was regarded as something of a left wing liberal (which is not a criticism from me) but I really question his motives when he is prepared to use such dishonesty,

Interesting that we are seeing some wage inflation in Portugal – I think its inevitable. Not that I think that dropping their wages will help either. If we except that the economy needs to rebalance towards exports and that probably means manufacturing then exactly how low do those wages have to go – $10 or $20 a day maybe? Even if it was possible to push people’s living standards down without provoking anarchy, why would global capital relocate to western countries whose domestic markets are shrinking as their citizens become ever poorer. And we would need lots of capital to rebuild the industrial infrastructure & supply chains. I just find it very unlikely.

The west can’t reverse globalisation – we can’t fiddle with a few economic knobs and reverse the massive changes of last 30 years. Its gone. I doubt very much we can go back to borrowing to consume either – the surplus countries are getting tired of that game. It worked for a while but now it looks too risky so they will pursue their own Plan B. The exception is Germany – locked in a Euro death embrace.

So either they tell the truth – we are going to be poorer – impossible in a modern democracy or they lie and cheat and try to fool the populace. I think we are seeing plenty of examples of the latter.

we can actually – but I doubt anyone in power will want it – they’ve too much invested in it .

but it can and does happen , in small ways , like Russia with holding wheat because of shortages

we deal and sell to dictatorships of all kinds all the time – with rules only our politicos can dream ( plan ) of , but they’re all in place, the laws, needed to crush us , just needs a trigger , a flash point , then

and you point about dropping wages – yes how can modern western industrial democracies allow it citizens to work for a dollar a day wages …..

the current method of allowing our 99% citizens to borrow money to keep pretending they’re wealthy is predictably coming to an end.

I expected the party to stagger on for a long time like a drunk down the road with his bottle of whiskey but in the end the ditch awaits

$20 a day to an agricultural peasant looks like heaven. $20 a day to us looks like hell.

I suppose the answer would be to compete on productivity i.e. automation but that assumes we have access to technology and critically energy that they don’t. I don’t see us having those competitive advantages any more. Europe in particular is critically short of energy – but thats a whole other discussion…

Perhaps our main advantage is proximity to the big western markets but not quite so useful if western markets are shrinking whilst eastern markets are growing.

Hi Kit
Although (sadly) for the Portuguese people the latest economic statistics discussed above expose the hype of their leaders. As for us we too have leaders who pump out hype but if we had a measure of undermeployment like the US U-6 measure I think that some of the gap between unemployment/employment and GDP would close.
Also with today’s retail sales numbers added to better construction and industrial production figures GDP looks likely to be revised up a bit too. Although care is perhaps needed with the use of “better” when it means less negative.

Hi Noo 2
net external demand = exports less imports
So it is possible that net external demand can improve by imports falling and exports remaining the same. We have seen examples of this type of thing in recent times in the Euro area.
As it happens some nuance is needed here as Portugal’s exports did grow albeit more slowly. But the improvement in net external demand was driven more by falling imports due to weak consumption in her economy. So the former is good but the latter is bad.

Quite the joke your “high-hearted assessment” of the Portuguese economy. In fact what you also ignore is 2 factors (before claiming hype or non-hype): (1) Most employment is construction and non-exporting industry based, a pure bubble factor has come in and is closing down hundreds of companies, the impact on the economy? Bank pressure, increase in government spend, does it really bear on the GDP (by the way went down 3.3%, is it that good?)? (2) Parallel economy makes unemployment actually a bit confusing… there are 3 or 4 regions in Portugal (20 to 25% of the population) that are in full employment and no one can be found for jobs, the problem is the industry in the Litoral North, Tourism in the Extreme South and Public sector jobs in the interior… the problem with Portugal is “where and what to spend”: salaries of “under”employed, construction projects where there are no infrastructural needs, pay raises for public servants? The government stopped that policy a year ago and so we’re bleeding, but is that really what you’re suggesting to come back to?